Market Viewpoints

Summary

Big electoral losses in the State legislature elections in the second and the fifth most populous states in Germany – Bavaria and Hessen – have dealt further blows to German Chancellor Angela Merkel and her ruling coalition. The move to the right (and in some cases far right) in recent elections in the US, UK, Germany, Austria, Netherlands, Italy, Sweden, Poland, Hungary and so on, indicates that, in the Western economies at least, the leftist parties have become rigid ideologues that no longer truly represent their people. Voters are therefore abandoning them and are willing to try new and untested political parties and personalities. This polarization is set to continue and, in Europe, the full effect of it will be felt in the upcoming European elections in May when the “populists” from across Europe take their seats in the European Parliament in Brussels in increased numbers. I believe Merkel is on borrowed time. Giving up the Chair of her party will increase the pressure on her to resign as Chancellor before her term ends in 2021. The Presidential election in Brazil, Latin America’s biggest economy and the world’s fifth most-populous country, brought another populist to power. Jair Bolsonaro is quite a controversial figure with polarizing views on many a topic. But the fact that Brazil still voted him in says how tired Brazilians are of the last 13 years of the Workers’ Party (PT) rule, during which time corruption, debt and the deficit soared and Brazil fell into its worst recession in more than a century. The last three Presidents of the country have all been implicated in scandals and bribery. There was a feeling that if the PT returned to power, it would pick up where it left off and eventually turn Brazil into another Venezuela. Bolsonaro has pledged to clean up politics, crack down on crime, end Brazil’s flirtation with socialism, privatize and deregulate, rein in deficits, and open up the economy. If he delivers on even half his manifesto, Brazil would be the winner.

Merkel: a lame duck Chancellor?

The unemployment rate in Germany is at a 40-year low. The trade surplus is at a record high and, last year, Germany, experienced its best GDP growth in a decade. Yet Germans seem unhappy with Chancellor Angela Merkel who has been Chancellor for the last 13 years. Ever since Merkel opened Germany’s borders to nearly two million refugees three summers ago, things have not been the same in Germany, either socially and politically. Germany’s political mainstream, dominated by the Christian Democratic Union (CDU) and the Social Democrats (SPD) has been on the retreat. Big electoral losses in the state legislature elections in the second and the fifth most populous states of Germany – Bavaria and Hessen – have dealt further blows to Merkel and her ruling coalition.

Earlier this month, the affluent Bavaria with a population of over 12.5 million and home to such companies as BMW, Siemens and Adidas, stunned the incumbent Christian Social Union (CSU) – sister party to Merkel’s CDU – when it lost its absolute majority, its worst result since 1950 (chart below). To pile on the misery, over the weekend, the State elections in Hessen – home to Germany’s financial industry- dealt another blow to the “grand coalition” parties – the CDU and the SPD with the CDU polling 27.9% and the SPD plunging to 19.8% (chart below). In the last election, in 2013, the CDU and the SPD scored 38.3% and 30.7% respectively. The far-right Alternative for Germany (AfD) which didn’t exist 10 years ago and became the largest opposition party in the German parliament in the general election last year, polled 13.1% to enter the Hessen state legislature for the first time. The AfD is now represented in all 16 of Germany’s regional assemblies and has built a solid base throughout Germany as it continues to gain traction with German voters.

More worryingly, both the CDU and the SPD have seen their national ratings plummet further since the federal election in September 2017. Last week, a nationwide Emnid poll found that the support for the CDU/CSU has shrunk to a record low of 24% (down from 32.9% in September 2017), while the SPD dropped from 20.5% to a lowly pitiful 15%. The AfD is now polling ahead of the SPD at 16%. The grand coalition of – the CDU/CSU and the SPD together now account for 39% of national support, a big fall from the over 67% support they enjoyed just over a year ago. German voters continue to show their disappointment with the open border policy of Merkel. A yearning for change is evident among CDU and SPD supporters, who feel betrayed by their leaders.

The move to the right (and in some cases far right) in the recent elections in the US, UK, Germany, Austria, Netherlands, Italy, Sweden, Poland, Hungary and so on, indicates that, in the Western economies at least, the leftist parties have become rigid ideologues that no longer truly represent their people. Voters are therefore abandoning them and are willing to try new and untested political parties and personalities. This polarization is set to continue and in Europe, the full effect of it will be felt in the upcoming European elections in May when the “populists” from across Europe take their seats in the European Parliament in Brussels in increased numbers. Until such time as the main political parties stop undermining their own people and betraying their values, things will only get worse and, in some countries, much worse than today.

Merkel is powerless to stop the erosion of support. This week she announced that she would not seek re-election as Chair of her party a post she has held for the past 18 years. But will that be enough? Can she cling on as Chancellor for the rest of her term ending in 2021? I believe Merkel is on borrowed time. Giving up the CDU chair will increase the pressure on her to resign as Chancellor before her term ends. So, what happens when she goes?

In the medium term, it will only increase worries as there is no clear successor to Merkel and therefore we won’t know what the new Germany will look like. A weak or uncertain Germany is bad for Europe. Serious decisions remain to be made on the future of the Eurozone: Migration, defence, the European Monetary Fund, the Italian budget deficit and other issues – let alone negotiating Britain’s exit from the European Union (EU). If Germany gets wobbly, the EU could drift untethered and directionless and stumble from one crisis to another.

Brazil turns right

Latin America’s biggest economy and the world’s fifth most-populous country, Brazil, has a new President – Jair Bolsonaro, a former army captain. Bolsonaro beat his left-wing rival Fernando Haddad by 55%-45%. For the first time since 1989, neither the Workers’ Party (PT) nor Brazil’s other political heavyweight, the centrist Brazilian Social Democracy Party (PSDB), has won the Presidency.

Bolsonaro is quite a controversial figure with polarizing views on many a topic. Perhaps a lot of it is loose electoral talk, but the fact that Brazil still voted him in says how tired Brazilians are of the last 13 years of PT rule, during which corruption, debt and the deficit soared and Brazil fell into its worst recession in more than a century. There was a feeling that if the PT returned to power, it would pick up where it left off and eventually turn Brazil into another Venezuela.

Brazil is still struggling to return to strong growth after GDP fell -3.9% in 2015 and -3.5% in 2016.

The recovery has been anemic and Brazil is struggling with unemployment of +12%, a high debt/GDP ratio of 80% and a worrying budget deficit of +7% of GDP.

The profligacy and corruption of 13 years of left wing government is largely responsible for the mess that Brazil is in. The last three Presidents have all been implicated in scandals and bribery. Luiz Inacio Lula da Silva, president from 2003–2011, was sentenced in July 2017 to nine and a half years in prison for corruption and money laundering. Dilma Roussef who succeeded Lula in 2011 was impeached and then removed from office in 2016. Michel Temer, Rousseff’s one-time running mate and Vice President took office in August 2016 after Rousseff was impeached and has since been charged with taking bribes. Brazilian voters have been so angry at the last 13 years that some took to referring to Bolsonaro as the best available “pesticide” or “chemotherapy” Brazil now has to protect itself from the PT’s return.

Mansueto Almeida, an economist at Brazil’s Finance Ministry explains that approximately two-thirds of the country’s budget goes towards paying old-age pensions, public health care and the payroll of Brazil’s bloated public sector. If this continues then by 2020 those liabilities will have grown so much that there will be nothing left over for discretionary spending items such as roads, new hospitals or police equipment. A debt crisis is looming. Brazil is one policy mistake away from ushering in a return of the IMF.

This election, therefore, was a choice between more of the same or a course correction and revival. Brazilians very wisely chose the latter. Reform will not be a cakewalk but more of the failed policies of the PT sure would be a road to perdition. While the media likes to label Bolsonaro as far right, for many in Brazil, Bolsonaro whose middle name means “Messiah”, is a saviour.

Bolsonaro has pledged to clean up politics, crack down on crime, and set a new direction for his country. “We cannot continue flirting with socialism, communism, populism, and leftist extremism … We are going to change the destiny of Brazil,” Bolsonaro said in an acceptance address, promising to root out graft and stem the tide of violent crime. Bolsonaro’s chief economic adviser is Paolo Guedes, a Chicago University-trained economist and investment banker advocating radical privatization and small government. However, the new President’s success will depend on his ability to unify a deeply divided nation and to find a majority in Congress in order to implement his reform agenda. While Bolsonaro’s Social Liberal Party is now the second-largest party in the lower house, it still has only 52 out of 513 seats. The Lower House remains split between ten parties that account for around 60% of the seats. There is a similar split in the Senate. Hence, forming a coalition will likely be tough. Bolsonaro backs an independent central bank, privatization and deregulation, fiscal austerity, opening the economy, and a move away from failed industrial policy. If he delivers even half that, Brazil will be the winner. Watch out for the Brazil equity index BOVESPA and the Brazil ETF (EWZ US).

Markets & Economy

Last week the equity market sell-off that so far had only hit Emerging Markets and Europe reached US shores and as it has wiped out all year-to-date gains of the S&P 500 (SPX) index, while leaving other indices in a sea of red (see table below)

So where to from here? What is the level that the SPX could fall to before it becomes an attractive buy?

If the sell-off in the US equities continues, it will be a case of throwing the baby out with the bathwater. US GDP expanded at the rate of +3.5% per annum in the third quarter. Consumer spending rose +4%, a stronger rate than the prior quarter and government spending picked up as well. The US economy is set to grow above a +3% rate during 2018. That hasn’t happened since 2005. At the same time, inflation cooled in the third quarter i.e. it should ease the pressure on the US Federal Reserve (Fed) to continue raising interest rates.

While it’s easy to turn bearish if the market is at an all-time high, there’s one thing I find contradictory about the bearish commentators out there. The same folks who say growth has peaked, seem to suggest that the Fed will keep increasing rates and therefore the sell-off will continue. Why on the earth would the Fed keep increasing rates if growth has peaked?

I don’t disagree that US growth may be easing with the second quarter growth of +4.2% being the peak quarterly growth of this business cycle – when the biggest impact of the Trump tax cuts was felt. If that is the case, then the Fed will again find it difficult to stay on the rate hike path i.e. equities should get support. A dovish hike in December, where the Fed raises rates but lowers the forward rate projections (dot plot) would be supportive for US equities as well as Emerging Market equities and bonds hit by a strong USD. If growth and inflation both fall back to +2% by mid next year then I would expect this rate cycle to top out at +3% and not +3.5%, as currently anticipated. A long pause from March – September 2019 would be enough to get equities higher again and steepen the yield curve for banks’ earnings to do well.

There’s one more thing to watch out for. Markets may be underestimating the amount of government spending that will come from already approved budget appropriations and we saw a sign of this in higher government spending figures in Q3 GDP released last week and mentioned above. A capital-spending program by the government would encourage companies to invest in capital and production in anticipation of nominal growth rather than financial engineering.

Based on the current earnings number of $175-$179 Earnings per Share (EPS) for 2019 and $165 in a bearish case, there’s strong support for the SPX at the 2650 level, i.e. at a P/E of 16. I expect the SPX to bounce back to the 2850 level and a dovish Fed in December could set it nicely for a test of 3000 in early 2019.

And let’s not forget that President Donald Trump is talking of another tax cut. The poll numbers for the US midterm elections have started moving back in favour of the Republicans and they look to retain the Senate comfortably. Generic ballot numbers still indicate a 50/50 House of representatives, as we head into the final stretch with the Democrats losing steam as more voters return to the red corner.

The next area to focus on would be the strength of the US dollar, with way too many Fed rate hikes priced in for 2019, if growth is indeed slowing. I would, therefore, increase exposure to Emerging Market bonds and equities in anticipation of US Dollar weakness. Also I would recommend a move into more value sectors – Energy, Industrials, and Financials.

While I am not concerned about the US economy in the short term, I am concerned about it in the medium to long-term.. Trump’s tax cuts and an increase in government spending means that, in 2020, the US will be borrowing more than $1 Trillion plus while the US economy will only grow by $400 billion (taking GDP growth at +2% for 2020). In other words, the US will be going deeper into debt at the rate of $600 billion a year. While stimulus-driven growth that borrows from the future is fun in the short-term, it’s not so good in the long run. So yes, 2019 and definitely 2020 will be big worries for the US economy, and the world, if growth slows down.

Meanwhile, in Europe, stocks fell as the tussle between Italy and the EU intensified. The EU took the unprecedented step of rejecting Italy’s draft budget as incompatible with the bloc’s rules on fiscal discipline. Yields on 10-year Italian government bonds have risen to +3.6% from less than +2% in May. European Central Bank (ECB) President Mario Draghi has refused to intermediate, however, he reiterated that Italy and the EU would come to an agreement. “I’m confident an agreement will be found,” Draghi said of the standoff.

Of course, nobody expected the EU to give in immediately, but they will give in eventually. The higher deficit may be the only way to avoid an economic crisis in Italy. Italy has a growth problem and needs the deficit spending to support growth. Arguing over whether the deficit should be -2% or -2.4% of the GDP is like arguing about what music to play on the Titanic after it hit the iceberg. Even if Italy accepts the -2% target, the deficit may slip to over -2.5% or even -3% if growth slows down further.

French and German banks are again exposed to Italy in a big way (chart below) as they were to Greek banks. French banks look particularly exposed. As of June, French institutions had some $316 billion (over 14% of France GDP) in Italian investments, according to the Bank of International Settlements (BIS). That’s much more than they ever had in Greece. German banks’ claims on Italy, at $91 billion (3.2% of Germany’s GDP), are smaller but still significant.

I continue to be long US equities, with sector preferences for Technology (XLK), Financials (XLF), Energy (XLE) and Industrials (XLI). I also recommend increasing exposure to European equities now that they have fallen to oversold levels – Financials, Industrials, Healthcare, Autos and Luxury stocks are my favourite sectors. An increased allocation to Emerging Markets equities is also recommended

And finally what happens after we’ve had a bad October? How soon does the SPX recover? Here are some stats from S&P 500’s history dating back to 1928, for October sell-offs of more than -4%:

In terms of stocks I like : VISA (V US), Blackrock (BLK US), JP Morgan (JPM US), Bank of America (BAC US), Goldman Sachs (GS US), Allergen (AGN UN), Celgene (CELG UW), Apple (AAPL UN), Google (GOOG US), Microsoft (MSFT US), IBM (IBM US), Amazon (AMZN UW), Salesforce (CRM US), Alibaba (BABA US), Micron Technology (MU US), JD.com (JD US), Home Depot, (HD UN), Costco (COST US), Estee Lauder (EL US), Glencore (GLEN LN), Rio Tinto (RIO LN), Freeport McMoran (FCX US), Alcoa (AA US), Honeywell (HON US), Schlumberger (SLB US), Halliburton (HAL US), CVS Health Corp (CVS US), BNP Paribas (BNP FP), Barclays (BARC LN), Pepsi (PEP US), Activision Blizzard (ATVI US), Starbucks (SBUX US), Disney (DIS US), Comcast (CMCSA US), Valeo (FR FP), Ford (F US), Societe Generale (GLE FP), Kering (KER FP), Mastercard (MA US).

Best wishes,

Manish Singh, CFA
Chief Investment Officer, Crossbridge Capital